What is Profitability Ratios?

As we know that every business is established with the only purpose of earning profit. Whatever the capital is invested in business, it must be able to get the adequate profit on this capital invested. Profitability ratios are the best way to analyse the success of the business and not only the success, even efficiency of the business can be measured with the profitability ratios. Profitability ratios are also known as Income Ratios. What is the definition of profitability? Profitability is the ability of a business to earn profit. Profit is the earning of a businessman. It is the remaining part of the revenue after deducting expenses from it.

How do you determine the profitability of a company?

Profitability can be determined with the help of various profitability ratios. Profitability ratios may be classifies into two categories:

Profitability Ratios related to Revenue from Operations (Sales):

Gross Profit Ratio

Net Profit Ratio

Operating Profit Ratio

Profitability Ratios related to investment:

Return on Total Asset or ROTA

Return on Investment or ROI

Return on Equity or ROE

Return on Equity shareholder’s funds

Earning per share or EPS

Dividend per share or DPS

Price Earning Ratio or P.E. Ratio

Gross Profit Ratio

As the name suggests, gross profit ratio shows the relationship between gross profit and Revenue from operations of a business. The formula to calculate gross profit ratio is:

The ratio is compared with earlier year’s ratio and important conclusions are drawn from such comparison. For instance, if there is a decline in gross profit ratio in comparison to the previous year, it may be concluded that:

Price of materials purchased, freight, wages and other direct changes may have gone up but the selling price may not have gone up in proportion to the increase in costs.

The selling prices may have fallen but the prices of materials, freight, wages and other direct charges may not have fallen relatively.

There may be misappropriation, theft or pilferage of inventories during the year.

There is fall in the sale of more profitable varieties of goods.

There is fall in the prices of unsold goods, thereby reducing the value of closed inventories.

Operating Profit Ratio

Operating Profit is arrived at by deducting all the operating expenses from gross profit, such as office and administration expenses, selling and distribution expenses, Depreciation, Discount, Bad Debts, interest on short term loans, etc. Non-operating expenses are not deducted from gross profit, such as loss on sale of fixed assets, loss from fire, income tax, charities and donations, finance charges relating to interest on long term debts and interest on debentures etc. Similarly, non-operating incomes (such as profit on sale of fixed assets, interest and dividend received on investments) are also not added into gross profit.

‘Operating Ratio’ and ‘Operating Profit Ratio’, these both the terms are inter-related. Total of both these ratios will be 100 in every case. For Example, if the ‘Operating Ratio’ is 80%, it means that the ‘Operating Profit Ratio’ is 20%. A rise in ‘Operating Ratio’ will lead to a similar amount of decline in ‘Operating Profit Ratio’ and vice versa.

Return on Total Assets (ROTA)

This ratio is a measure of the profitability of the total assets of a firm. It is also called ‘profit to assets ratio’ and is usually expressed as percentage. Objective of computing this ratio is to assess how efficiently the assets have been used by the management in earning profits. ROTA is calculated as per the following formula:

Significance: This ratio shows that how efficiently the total assets of a business is used by the management. The higher the ratio, the better it is, because the higher ratio means that assets are being utilised efficiently in earning profits.

Return on Investment or R.O.I

The only purpose of doing investment in a company is to get some return on that. the return on this investment is known as Profit. ROI shows the profitability of a company. This ratio is calculated by comparing the profit earned by the company and the amount of capital employed to earn this proft. This ratio is known by other names also like ‘Rate of Return’ or ‘Return on Capital Employed’ or ‘Yield on capital’.

The term ‘Investment’ here refers to long term funds deployed in the enterprise. As defined earlier long term funds are also known as Capital Employed which means total of shareholders’ funds and long term loans.

The ratio is computed as under:

Since the capital employed includes shareholder’s funds and long term loans. Interest paid on long term loans will not be deducted from profits while calculating this ratio.

Capital employed can be calculated by any of the following two methods:

Significance: This ratio shows that how efficiently the shareholder’s money is utilised by the firm. It shows the amount of profit the company is earning on the shareholder’s funds. Relative profitability and strength of the firms can be shown by comparing this ratio of a company with that of other companies.

Return on Equity Shareholder’s Funds

As the return on total shareholder’s funds is calculated to see the profitability of the company on the shareholders fund, this ratio is calculated to see the profitability of the equity shareholders’ funds. This shows the profitability of the money which belongs to the equity shareholders. Equity shareholders are paid profit after the payment of interests, taxes and dividend on preference shares.

Significance: This ratio shows that how efficiently the equity shareholder’s money is utilised by the firm. It shows the amount of profit the company is earning on the equity shareholder’s funds. Relative profitability and strength of the firms can be shown by comparing this ratio of a company with that of other companies. Similarly, by comparing the previous year’s ratio with that of the current year of our business we can ascertain whether the return on equity shareholder’s funds is increasing or not. The ratio may also be used for declaration of dividend and creation of reserves for future growth

Earning Per Share (E.P.S)

This ratio measures the profit available to the equity shareholders on as per share basis. All profits left after the payment of tax and preference dividend are available to equity shareholders. This ratio is calculated by dividing the net profits available to equity shareholders by the number of equity shares issued.

Significance: This ratio is the main basis for calculating the market price of the equity shares. Capacity of the company to give dividend on equity share capital can also be estimated with the help of this ratio.

Dividend Per Share (D.P.S)

Profits which is available after the payment of interests, tax and preference dividend for the equity shareholders, is not fully distributed among the equity shareholders. A part of this [rofit is retained in the company for future purposes and the remaining profit is distributed among the equity shareholders as dividend. Dividend per share ratio shows the amount the dividend paid to each equity share.

This ratio is simply calculated as:

Price Earning Ratio

It is calculated by dividing the market price of a share by the E.P.S. That is,

This ratio shows how many times the market price of share in comparison to its earning is. The ratio is used to measure whether the market price of a share is high or low.